The factors that have moved the market up for the last five years are eroding.  Contrary to popular conception, the economy shows no sign of entering a new phase of more robust growth.  Quantitative Easing (QE) is being gradually withdrawn, and on its current schedule, will end by November.  Technically, the market has shown significant signs of topping out.  In the absence of stronger economic growth, corporations will have a difficult time increasing earnings.  The market is substantially overvalued by historical standards.

A number of key economic indicators have now been reported for March or April, and is not encouraging for investors expecting a big bounce back from the cold winter.  The housing market was particularly disappointing. New home sales in March were down 14% from February, and down 13% from a year earlier.  Mortgage purchase applications in April are off 16% year-over-year.  Existing home sales were about flat in March, and down 7% from a year earlier.  The pace of sales was about the same as in June 2012.  Housing starts were up 3% in March, but off 6% year-to-year.  The March NAHB Housing Index crept up to 47 from 46, near its lowest level in a year.

Industrial production for March rose 0.7% from the previous month, but only 3.8% from a year ago, well within the prevailing range of the last three years. Although investors cheered a March increase in retail sales of 1.1%, the year-over-year gain was a weak 3.8%, compared to 4% before the extreme cold weather set in, and nowhere near the recovery peak of 8.5% in July 2011.  The March jobs increase of 192,000 was 1.66% above a year earlier, but was up 1.82% on an annual basis in November.  In prior economic recoveries, jobs typically rose from 3%-to-5% annually for months at a time.  New orders for durable goods ex the volatile transportation and defense sectors were up 3.5% year-over-year, down from an annual rate of 8.8% in September.  

If the Fed sticks to its current plan, QE will end in November.  In the last few years QE has been started and stopped a number of times.  A study by Bianco Research found that the S&P 500 rose 117% during periods when QE was in effect and declined 27% when it ended.  Although QE is being ended gradually this time instead of suddenly, we believe that the winding up of the program will be a headwind for the market in the period ahead.

In the last five years corporate earnings have soared despite weak revenues that have mirrored the tepid growth in GDP.  This feat was accomplished largely through keeping a lid on new hiring, holding down spending on new plant and equipment, and buying back stock, mostly with funds raised through new debt issuance. This is not a recipe for sustained earnings growth.  In addition, the S&P 500 is selling at 21 times cyclically-smoothed earnings, a level exceeded in the last 90 years only in 2000 and 2007.   

As we pointed out in recent comments, the market has also taken a turn for the worse on a technical basis.  The momentum stocks that led the market have declined sharply and bounced back weakly.  Many of these stocks have no earnings while those that do are selling at nose-bleed valuations reminiscent of the 2000 and 2007 market peaks.  The S&P 500 has flattened out while Nasdaq has broken a ten-month rising trend line. The partial bounce back has still left it below its 50-day moving average.  Sentiment is still heavily bullish and the number of stocks making new daily highs has been dropping.

In our view, the upside potential for the market is exceedingly limited and the downside risks are high.